Alternative Tax Could Hit Middle-income Families

Personal Finance

Many middle-income families will be shocked next year to find out that Uncle Sam considers them rich.

They will be hit by the alternative minimum tax, which was designed in the late 1960s by Congress to make sure the truly wealthy didn't escape taxes through generous deductions and loopholes.

The problem is the tax was never adjusted for inflation. So the AMT has begun wrapping around more middle-income families. Households with incomes of $75,000 -- hardly enough to move beside Bill Gates -- can be hit by the AMT if they take enough deductions, some experts said.

Additionally, President Bush's tax cuts didn't benefit some taxpayers as much as they had hoped. Taxpayers essentially figure their tax bill under the regular income tax and the AMT, and pay whichever yields the most for the government. The cuts lowered regular tax rates but left AMT rates alone, increasing the chance that filers will owe more under the AMT.

"Everyone seems to think this is someone else's problem. It will be their problem, too," said Cliff Gladson, a portfolio manager with USAA, a financial-services company catering to military families.

In 2001, about 1 million taxpayers paid the AMT, according to the Congressional Budget Office. The AMT rolls are likely to grow to nearly 30 million, or 20 percent of taxpayers, paying about $90 billion in AMT in 2010. Taxpayers with adjusted gross incomes of between $100,000 and $500,000 will bear the brunt, with 90 percent of them owing AMT.

Financial experts don't expect a permanent fix from Congress and the Bush administration because of the soaring deficit. Eliminating the AMT would cost about $600 billion in the next decade, and indexing the tax for inflation would reduce revenues by $370 billion over 10 years, according to the Congressional Budget Office.

"It costs so much to fix it, they can't afford to fix it," said Jere Doyle, senior director at Mellon's private wealth management group in Boston.

What can a taxpayer do?

Unfortunately, if you've already been snagged by the AMT, there's not a lot that can be done, unless your financial situation changes, experts agree. Still, there are steps you can take to make sure you don't exacerbate the problem.

One of the first steps is figuring out whether you're a candidate for AMT.

"If they itemize deductions, they have to keep it in mind," said Carol Katz, a Baltimore accountant.

What makes the AMT so complicated is the rules are so different from those for the standard 1040. AMT doesn't allow the same deductions as regular income tax. Filers use Form 6251 to calculate AMT.

"It's a parallel universe. It's like a Bizarro tax system," said Gladson, referring to the Superman comics in which everything is backward. "It's a nightmare."

A combination of factors can push filers into the AMT. Those most likely to owe tax under it are residents from states with high property and income taxes -- New York, California, Maryland -- because these taxes aren't deductible under AMT.

Also, families with several children can be hit by AMT because personal exemptions aren't allowed. Miscellaneous deductions, which include work expenses not reimbursed, can trigger AMT. So can exercising incentive stock options.

AMT has two tax rates, 26 percent and 28 percent. Because of the topsy-turvy formula, filers sometimes find themselves trying to accelerate income the year they face AMT and putting off deductions to another year when it can do them more good. That's the opposite of the strategy used by those paying regular tax.

Taxes are important, but they shouldn't drive investment decisions, experts said. Still, when investing, here are some AMT factors to consider:

Municipal bonds: Many investors buy municipal bonds because the income isn't subject to income tax. But be aware that municipal "private activity" bonds issued to help finance private-sector projects, such as stadiums or airports, are subject to AMT.

Still, the bond funds can call themselves tax-free as long as no more than 20 percent of their holdings or income is taxable.

As concerns about AMT have risen, some bond funds have changed their names in the past year to emphasize that they are AMT-free, said Scott Berry, a senior analyst with Morningstar Inc.

Fidelity Investments went further, saying that its five municipal money market funds no longer would invest in any bonds subject to AMT.

This doesn't mean investors should shy away from private activity bonds. If AMT is not a worry for you, private activity bonds can be a good option because their yield is higher than those of other municipal bonds, said John Nersesian, managing director of Nuveen Investments' wealth management group in Chicago.

Incentive stock options: Before exercising these options, which can trigger AMT, consult with a professional who can explain the tax implications, Katz suggested.

"If they don't call a tax professional first, they find out these horror stories later," she said.

The bear market, for example, left some who exercised options with a huge AMT bill and nearly worthless shares.

Roth IRA: Investing in this individual retirement account isn't a tactic to avoid AMT next year, but it can help you down the road, Gladson said.

Investors who are eligible for a Roth don't get a tax deduction for their contributions, but the money grows tax-deferred, and investors in retirement can withdraw the cash free of taxes, including AMT.